Golub Capital BDC: The Joys of Fee Income

Golub Capital BDC, (NASDAQ: GBDC) makes money in two ways: First, by making loans to companies, and second, through managing the money that it uses to make the loans.

In this installment, we'll look at the BDC business and how Golub profits from it.

How do BDCs work?BDCs function a lot like private equity funds, except that they're (usually) publicly traded and required to adhere to certain operating standards.

In essence, BDCs are required to invest primarily in certain "qualified assets," to earn at least 90% of their income from these sources, and to distribute at least 90% of their taxable income to investors. In addition, BDCs are required to meet diversification requirements and provide managerial assistance to their portfolio companies -- the "business development" part of the equation.

From an operational standpoint, they're often compared to REITs, which operate in a largely similar way.

Fee structures Of course, you don't invest in a BDC for free. In the case of Golub, the portfolio is managed by an external manager, meaning that these activities are outsourced.

You might notice many of the same faces populating the leadership of Golub, GC Advisors (its external manager), and Golub Capital the private equity fund. This somewhat complex structure makes it easier to take advantage of the more generous fee structure allowed by having an external manager: external managers must be registered with the SEC as investment advisors and can charge advisory fees, whereas internally managed BDCs can only pass on operating costs. Today, most BDCs are managed externally.

What are those advisory fees? They come in two flavors. Golub's annual management fee is 1.375%. Generally speaking, management fees cover the cost of operations: paying for staff, overheads, research, etc. The fee is charged on all assets except for cash and equivalents, and it is notable that it charges the fee on total assets, instead of just what shareholders put in. This means that fees are higher if leverage is used. (Please note: It's technically GC Advisors that charges these fees, but for the sake of simplicity we'll just say "Golub").

The incentive fee is based on the performance of the portfolio, and thus includes both portfolio income and capital gains. In Golub's case, the income-based incentive fee is based on dividends, income from originations, consulting fees, due diligence, and related activities, and it excludes operating expenses.

Golub doesn't charge the fee if these income sources return less than 2% in a given quarter. If returns are between 2% and 2.5%, Golub gets 100% of the income, and if they're above 2.5% Golub takes 20%. The rest is distributed to shareholders.

There is also a capital gains-based incentive fee, which is calculated once per year. This fee is based on realized capital gains, realized capital losses, and unrealized capital depreciation. If realized capital gains are greater than realized and unrealized losses, it takes a fee; if not, it doesn't. Golub has not yet taken this fee.

What are the benefits and drawbacks of this structure? You've probably heard grumbling in the media about private equity fees, most notably around the "two-and-20" structure of 2% management fees and 20% incentive fees. The major criticism is that, beyond a certain size, funds don't really need to take large management fees in order to cover their costs -- after all, this isn't exactly a capital intensive business.

That's why it's always good to have a basic understanding of what a BDC is charging you. Golub is pretty modest with its 1.375% management fee, which makes sense considering its strategy, but management fees can go higher -- Prospect Capital, by comparison, charges 2% annually (and, it is worth noting, has a pretty different business model).

The risks to investing in this business model are two-fold. One is the temptation to raise a lot of capital in order to generate higher management fees -- resulting in more capital than is needed, and possibly a commensurate loss of interest in making good deals. Another is attempting to juice returns in order to make more money from the incentive fee. This might be fine by you if things are going well, but it's a strategy that can backfire if the bottom slips out.

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